Business Economics (A) Researcher training course 8th week Yuji Honjo Faculty of Commerce Chuo University

2 Contents  Theme The Dynamics of Pricing Rivalry  Keyword Fork Theorem Cooperative pricing  Discussions Do you think what is the most important for the sustainability of cooperative pricing?

3 Coordination  Cooperative pricing If the discount rate i is not too large, then the cooperative outcome will be sustainable.  Fork theorem  Coordination problem The fork theorem implies that cooperative pricing behavior is a possible outcome in an oligopolistic industry.  But there is no guarantee that cooperative pricing will emerge. Achieving cooperative pricing when other, less attractive outcomes are possible is a coordination problem.

4 (Continued) cf. Collusive agreement A collusive agreement (i.e., cartel) is illegal in most countries. Corporate pricing != Collusive agreement  Coordination without an agreement Achieving coordination without an agreement or overt communication is far more difficult. To succeed, cooperation must be a focal point for all the firms. Do focal points, in practice, emerge in economic or social interactions?

5 cf. Experiment in the Class  Revised version of a game “ Divide the Cities ” First, you have the score of 16. The total number of cities is 16. You cannot ask others whether the city is chosen (no collusive agreement). When you choose the city others choose, the score is -1. When any of you does not choose the city, the score is -1. If the total score is over 10, I will treat you to lunch.

6 Exercise 1  16 cities Atlanta Baltimore Boston Chicago Detroit Florida Houston Honolulu Indianapolis Los Angels New York Philadelphia Phoenix San Diego San Francisco Seattle

7 Exercise 2  16 cities Bangkok Beijing Berlin Delhi Hong Kong Kuala Lumpur London Milan Moscow Osaka Paris Seoul Singapore Shanghai Sydney Tokyo

8 Why Is Tit-for-Tat So Compelling?  Is Tit-for-Tat the only strategy? Answer  No!  Grim Trigger Strategy If any firm deviates from the cooperating price, the others will drop its price to marginal cost in the next period and keep it there forever.  This strategy gives an incentive to keep the firms from undercutting their prices.  But, in practice, the tit-for-tat strategy is more effective. Why?

9 (Continued)  Reasons for firms to choose the tit-for-tat strategy A firm can easily signal to its rivals that it is following tit- for-tat. cf. The trigger strategy may provide signal for simple price competition when its rivals cannot understand the trigger. The Evolution of Cooperation by Axelrod  Niceness  Provocability  Forgiveness

10 (Continued)  Misreads A firm mistakenly believes a competitor is charging one price when it is really charging another, or A firm misunderstands the reasons for a competitor ’ s pricing decision Cf. Dixit and Nalebuff ’ s (1991) argument  When misreads are possible, pricing strategies that are less provocable and more forgiving than tit-for-tat are desirable.

11 How Market Structure Affects the Sustainability of Cooperative Pricing  Cooperative Pricing Market structure conditions influence the attainment of cooperative pricing.  Market structure conditions Market concentration Structural conditions that affect reaction speeds and detection lags Asymmetries among firms Price sensitivity of buyers

12 Market Concentration and the Sustainability of Cooperative Pricing  Market Concentration The benefit-cost ratio in equation (8.1) goes up as the number of firms goes down. The more concentrated the market, the larger the benefits from cooperation. Coordinating on a particular focal strategy is likely to be easier for less firms there are compete against one another in the market.

13 Reaction Speed, Detection Lags, and the Sustainability of Cooperative Pricing  Reaction Speed If price cuts can be matched instantly, cooperative pricing will always be sustainable.  A firm may be unable to react quickly to its competitors ’ pricing moves because of Lags in detecting competitors ’ price Infrequently interactions with competitors Ambiguous in identifying which firm among a group of firms in a market is cutting price Difficulties distinguishing drops in volume due to price cutting by rivals from drops in volume due to unanticipated decreases in market demand

14 (Continued)  Important factors for cooperative pricing Lumpiness of orders  Lumpy orders reduce the frequency of competitive interactions between firms. Information about sales transactions  While some prices are publicly posted, other prices are secret. The number of buyers  It is easier to detect deviations from cooperative pricing when each firm sells to many small buyers than when each sells to a few large buyers. Volatility of demand and cost conditions  Price cutting is harder to detect when market demand conditions are volatile.

15 Asymmetries among Firms and the Sustainability of Cooperative Pricing  Asymmetries among Firms Firms are not identical  Firms have different costs.  No single focal price  Cooperative pricing – difficult  Two related reasons for the difficulty Large firms benefit more from the move toward cooperative pricing than does small firms. Small firms anticipate that large firms have weak incentives to punish a small firm that undercuts its price.

16 Case: Dot Matrix Printer in South Africa  Epson vs. Panasonic Epson – Leader firm in South Africa Epson ’ s price: Rand 1,000 Panasonic ’ s price: Rand 950 (5% discount)  Capture a fraction α of demand  Epson ’ s profit if Epson matches Panasonic ’ s price of Rand 950 (950 – 500) * 1,000 = 450,00 if Epson does not match it (1,000 – 500) * 1,000 * (1 – α) = 500,00 (1 – α) If α < 0.01 (Epson expects to lose less than 10 percent of its business to Panasonic), then not matching is optimal.

17 (Continued)  Price umbrella By allowing Panasonic to sell printers at a lower price than it charges, Epson would be extending a price umbrella to Panasonic.  Price umbrella is optimal when ((1 – β) P – C) * Q < (P – C) * Q * (1 – α) – βP < – α (P – C) α < β/ PCM The price cut, β, is relatively large, but the price cutter does not steal much market share form the larger firm The margins in the industry is relatively small

18 Market Structure and the Sustainability of Cooperative Pricing (See Table 8.1.)

19 Facilitating Practices  Firms themselves can facilitate cooperative pricing by Price leadership Advance announcement of price charges Most favored customer clauses Uniform delivered pricing  These practice either facilitate coordination among firms or diminish their incentives to cut price.

20 Quality Competition  Quality Another factor drives consumer decision and firm strategies.  Quality choice in competitive markets Information  Important cf. Lemmon market  Consumers cannot gauge the quality of the product.  Quality choices of sellers with market power Marginal cost of increasing quality Marginal benefit of improving quality